How Hedge Funds Trade the Forex Market
Unlike small individual investors and traders who are strongly enticed (by brokers) to engage in very high frequency trading, successful hedge funds engage in fundamentally based, well researched long term objectives where they may trade on multiple time frames according to the overall long term price trend they expect.
They do this by trading slowly, much slower than most day traders, and by trading very big size). They take a very selective approach which may provide opportunities in different countries and currencies based on their geopolitical and economic analysis in that particular region.
The Carry Trade Strategy
The Carry Trade strategy involves selling a low interest rate currency and buying a high interest rate currency, is like borrowing money from a low interest bank and depositing it with a high interest bank, it generates constant profits even if the currency pair in question doesn’t move at all. But it is also an open forex position which if predicted right it will also make a big profit on the price movement, or a big loss if predicted wrong, this profit or loss will be much bigger than the profit made from interest.
So good hedge funds make sure they predict their Carry Trades, with risk, but it’s calculated risk and they hedge this risk through other currencies or through instruments on other currencies or even commodities. For example, a Carry Trade on the Canadian Dollar, or US dollar can be (partially at least) hedged against big risk by taking an appropriate trade on Crude oil, or some other commodity.
Canadian dollar is correlated to crude oil, while the US dollar is correlated to other commodities, inversely correlated to crude oil for moderate movements and actually correlated to crude oil for large, sustained price movements. Hedge funds do their geopolitical and fundamental analysis homework on these factors, and they will implement a Carry Trade in the safest way possible.
Every Country is Unique
Successful hedge funds don’t engage in generic investment ideas, they do research and analysis seeking to spot untapped markets, they take into account all kinds of relevant factors, especially data such as imports/exports relating to a country’s economic strength and future demand for its currency.
Canadian dollar is correlated to crude oil because Canada is a big oil exporter with huge untapped reserves, these reserves are only worth extracting as long as the price of crude stays above a certain level, if crude price drops significantly then Canada’s reserves in oil sands will become worthless once more and other countries such as Russia and Saudi Arabia will gain larger market share. It is things like these that hedge funds have to predict before investing in a country’s currency.
So in our example, there’s no guaranty that crude oil price will keep on rising and rising, a sudden breakthrough in physics such as the invention of cold fusion will completely crash the oil market once and for all, since cold fusion can provide astronomical amounts of clean and cheap energy and crude oil use will be limited to raw materials manufacturing only. This is an example of how risky markets are and how seemingly safe long term commodity investing can crash at any year, thereby crashing the related currencies with it.